I am a director of the law firm Grant & Eisenhofer, P.A. in Wilmington, Delaware. My firm primarily represents institutional investors, many of whom are members of the Council of Institutional Investors. I was asked by the Council of Institutional Investors to share some of our experiences and observations with you. However, my testimony is my own personal view and does not represent an official position of the Council of Institutional Investors or Grant & Eisenhofer, P.A.

I assume that the Commission will find little support for its proposed rules on auditor independence, for it is most constituencies' self-interest to leave the current rules as is. I do recognize that there may be some wide-spread support for some small portions of the rules, such as the example that has been given about the non-auditor spouse owning stock in his/her 401(k) plan. However, that is not the crux of the proposed rules. Let us look at the different constituencies:

The Corporations

The current rules give the corporations the most flexibility. Those who want auditors without any potential conflicts, who want independence without reproach, can simply refuse to hire their auditors for any consulting work. Those who choose to have a cozier relationship with their auditors, either because they foresee some benefit from having the auditor provide consulting work or because they want additional incentive for the auditor to be cooperative, will hire the auditor for consulting assignments. The proposed rule has no effect on the former category and a negative effect on the latter.

Accountants

The accountants, no matter how they sugar coat it with the public interest, see these rules as a threat to their economic well-being. The proposed rules will eliminate them from the high margin consulting business for the clients with whom they have the closest relationship.

Plaintiffs' Bar

The traditional plaintiffs' bar supports the current rules that allow accountants to reap large consulting fees from their audit clients because it provides the best indication of scienter that the plaintiffs' bar can find to support their securities fraud lawsuits. With the Courts raising the standards by which plaintiffs must plead scienter, the accounting industry's own greed, in obtaining large consulting fees from audit clients, provides this necessary element.

The Investor

The only group that is likely to support the proposed auditor independence rules is the investor, and more likely - - the institutional investor. Institutional investors read and rely on the audited financial statements of issuers. Institutional investors feel comfortable in this reliance primarily because of the existence of an independent watch dog - the auditor - rather than because of the threat of a securities fraud lawsuit. If this watch dog turns out to be nothing more than a Chihuahua with a tiny yap to which no one listens, the entire confidence in the financial reporting system is shaken. Thus, my clients - - the Institutional Investors - - need an independent loud barking watch-dog who is not distracted from its job by sticking its face in the food bowl.

Recent Experiences

It is unlikely that an auditor will ever concede that the reason it took a certain accounting position was to protect its consulting business. Similarly, it is unlikely that a case will ever go through trial in which a specific finding through a jury interrogatory is made in which an auditor is found to have breached its duty in order to obtain (or retain) consulting business. Therefore, one can really only look to anecdotal evidence to see if there is a problem with auditors taking on consulting assignments.

In one case, we came across an auditor who found problems with the company's accounting system. The auditor was lax for at least two years and did not hold the company accountable for these system failures. In year three, the company's computeraccounting system was sufficiently poor that the auditor called it to senior management's attention. However, rather than raising this with the audit committee, the auditor asked for, and received, from senior management, the opportunity to bid on the consulting assignment to fix the financial system problems. While it is certainly a good thing for the accounting system to be fixed, one must wonder whether the auditor would have been more aggressive, or called these problems to the attention of the audit committee, if it had not been interested in obtaining the consulting contract to fix the accounting system.

In another case we came across an accounting firm whose billings for audit and consulting work were in the eight figures. For at least three years, and in many cases five years, the audit firm had warned the company that its accounting positions were too aggressive and that specific and substantial corrective measures had to be taken. The company agreed to make changes but each year the same problems arose. The auditors continued to give clean audit opinions at the same time that they were highly critical, internally and to a lesser extent to the company, of the company's accounting positions. One again wonders if the client was not generating such substantial revenues for the auditor (in both audit and consulting work) whether the auditor would have been more likely to go public with its concern or refuse to issue clean audit opinions. The auditor was sued and eventually settled for an amount in the high eight figures.

A final example is the auditor of a company who had a catastrophic failure of its accounting system such that it was unable to accurately determine its accounts payable or accounts receivable. Nevertheless, this company continued to put out financial statements that were either reviewed (quarterly) or audited (annually) by its accounting firm. The public remained deceived until such time as state regulators did an audit and discovered the company's problems. Once this was disclosed, the company's stock price declined by over 60%. In this case, the auditors were not the consultants who had provided the accounting system nor were the auditors the ones who discovered the problems at the company. However, if the auditors were the ones who set up the computer system, what is the likelihood that the audit would have discovered the problems, and if so, that those problems would have been disclosed.

In the above example, it is not only the financial pressures that challenge the integrity of the auditor, but also the difficulty of being a watchdog over one's own colleagues. Isn't there the temptation in the above example not to test the systems but rather to have a level of comfort that the systems are fine because one's pal down the hall did the installation.

Conclusion

Whether auditors' independence is truly compromised by taking on the various business activities that are proscribed by the proposed rules is, to me, not the central question. The central question is simply is there a reasonable debate over the questionof the independence of auditors. If the answer is yes, and I believe that to be so, the potential for a lack of confidence, particularly among investors, financial institutions, lenders and the like is enough, for me, to counsel in favor of the proposed rules. For if the confidence in the financial reporting system that exists in the markets today is ever undermined, the consequences to our country's economy will be disastrous.

While we support the proposed rules and applaud the Commission for taking on this needed, yet unpopular, change, we think it does not go far enough. A strong argument can be made for a rule that prohibits auditors from any other work for the client other than audit and tax. Many companies, and institutional investors, voluntarily follow this practice. Until we get there, there will always be that element of doubt.